Retirement accounts can't guarantee security

There's a belief that investment firms are licking their chops over the prospect of individual Social Security accounts. President Bush favors such accounts, and financial stocks have jumped since he was re-elected.

But "thrusting the responsibility back onto the individual, while looking good on paper, would conjure up some practical challenges," he says. "You have to ensure that people who are stewarded (with their Social Security money) are well versed in investment and asset-allocation theory. It's not all that easy to do across a huge swath of Americans."

James Riepe, vice chairman of mutual fund firm T. Rowe Price, says his company may or may not be interested in private Social Security accounts.

"It depends on how it is put together. If you've got hundreds of thousands of little teeny accounts, that's not a business, frankly, we can do efficiently," he says.

But if the government does all the record keeping and workers can direct a large chunk of their Social Security tax into mutual funds, "it would get up to scale much faster, and organizations like ours would be interested," says Riepe, who is also chairman of the Investment Company Institute, the fund trade group.

There are many ideas floating around for setting up individual Social Security accounts. Bush has not endorsed any particular one.

In 2001, Bush appointed a bipartisan committee to study the issue. It came up with three options, all of which would let workers divert part of their Social Security payroll tax into private accounts that could be invested in stocks, bonds and other fixed-income investments.

Today, workers pay 6.2 percent of wages in Social Security taxes, and their employers pay the same amount. Self-employed people pay the full 12.4 percent.

The tax stops once an employee's income for the year hits a certain amount: $87,900 this year and $90,000 next year.

Reallocating Social Security

Under the bipartisan commission's Plan One, employees could divert a certain amount of their Social Security tax, such as 2 percentage points, into a private account. At retirement, traditional Social Security benefits would be reduced by the employee's total contributions to the private account, compounded at a real (after-inflation) rate of 3.5 percent per year. The employee would be better off in the private account if it earned more than 3.5 percent a year after inflation.

Under Plan 2, employees younger than 55 could redirect 4 percentage points of payroll tax, up to $1,000 a year, to a private account. Their retirement benefits would be reduced by their contribution compounded at a real interest rate of 2 percent.

Under Plan 3, employees younger than 55 could redirect 2.5 percentage points of their payroll tax into a private account, but only if they also put in new savings equal to 1 percent of their wages. Their retirement benefits would be reduced by their contributions compounded at 2.5 percent real rate. Low-income people could get a tax refund for their 1 percent in new savings.

The idea is that employees could get a better return on their investments than from Social Security by investing part of their money in stocks. Social Security invests its surplus funds in Treasury bonds.

Stocks have provided a better long-term return than bonds. But that is because they are riskier. A worker could retire at the beginning of a bear market, just when the value of his or her private Social Security has taken a nose dive.

Bridging the gap

All of these plans would be optional for employees and all would require a "transition investment" into the Social Security trust fund to make up for money diverted into private accounts.

The report estimates that Plan 1 would require the largest transition payment, of $1.1 trillion. Other estimates have put the transition payment closer to $2 trillion.

The transition payment would probably come from tax increases or spending cuts.

An even more radical bill, sponsored by Rep. Paul Ryan, R-Wis., would let employees under 55 divert 10 percentage points of the 12.4 percent Social Security tax into private accounts.

The proposals are billed as ways to "fix" Social Security by gradually shifting risk and responsibility from the government to individuals. It would essentially transform Social Security from an insurance policy/welfare program into a savings account.

A similar trend has been taking place in the workplace, as employers rapidly replace defined-benefit plans with defined-contribution plans.

In a traditional defined-benefit plan, the employer contributes all or most of the money, hires a professional to manage it and promises employees a certain monthly income in retirement -- which is the defined benefit.

In defined-contributions plans, such as 401(k) plans, the employee diverts part of his or her wages into a personal account. Sometimes, the employer makes a matching contribution. The employee decides how to invest. The employee's retirement income depends entirely on how much and how well he or she invested.

In 2002, there were only 32,300 defined-benefit plans and 810,000 defined- contribution plans.

Shrinking savings

If this trend continues, the three legs of the proverbial retirement -- personal savings, company pension and Social Security -- will soon be just two. If Social Security also becomes a quasi-individual plan, the stool could be left with a precarious 1.5 legs.

This has some investment professionals worried.

"We are among the largest managers of defined-benefit and defined- contribution plans," says Barclays' Scanlan. "One of the studies we have undertaken shows a persistent gap between portfolios that are individually managed versus portfolios managed by investment professionals."

Defined-benefit plans have outperformed defined-contribution plans by about 2 percentage points per year, he says. That small difference can mean the difference between scrimping and splurging in retirement.

"Individuals, frankly, don't all have equal financial skill in determining their superior asset allocation based on a long-term set of criteria," says Scanlan.

Often, young people, who can afford to take a lot of risk, end up in overly conservative options, while older people -- perhaps worried about the puny size of their nest egg -- get into overly aggressive investments.

Administrative costs

It's also much cheaper to manage a defined-benefit than a defined- contribution plan.

Plan costs vary greatly and depend greatly on account size. According to the Congressional Budget Office, it costs the government just $11 per person to run Social Security.

By comparison, a Fidelity executive testified that the average cost of managing a 401(k) account with a $55,000 balance was 0.58 percent, or $320 a year.

And that's a bargain. The average cost of running a 401(k) plan is between 1 and 2 percentage points of assets per year.

Catherine Gordon, a principal with the Vanguard Group, says her firm would need to know more about the details before taking a stand on Social Security.

"We are in favor of anything that helps provide people with a secure retirement," she says. "But there are a lot of things we can do (to improve Social Security) that would not require privatization ... such as extending the retirement age or modifying benefits somewhat."

Riepe, of T. Rowe Price, says "privatizing Social Security may be one of several solutions that should be considered."

His preferred solution: Return Social Security to its roots, as a safety net for those who really need it. Tell people from the get-go that if they do well in their careers and accumulate substantial savings, they won't get Social Security. Then give them new incentives and ways to save.

"I always thought the IRA was brilliantly simple. Then they took the deduction away for most people," he says.

For starters, the government could restore the IRA deduction for all workers. To plug the hole in the Social Security trust fund, the government could improve its own return on investment by putting some of its surplus funds in the stock market.

This is a highly controversial solution, because it would give the government a big stake in most companies. Although the government could give up its proxy voting rights or assign them to someone else, the political pressure to interfere in corporate affairs -- or to buy or not buy certain stocks for social issues -- could be too big to resist.